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Loss Aversion is a Path to Mediocrity

The story of great companies degenerating into good ones is a common one. What happened to Nokia in the cell phone industry or Dell in the computer industry? What happened to Circuit City or AOL? Even closer to home, what about companies that at one time were going to disrupt the world and went from almost great to truly mediocre? Groupon? Zynga? While different aspects of business strategy and execution were certainly at work, the one consistent factor across companies who were “almost great” or “formerly great” is that they develop a culture of loss aversion. In a strange way, the most risk-seeking of individuals, start-up entrepreneurs, can very quickly forget the greatest asset they had in building their companies – a willingness to take irrationals risks, and tolerate losses if they fail. They can quickly become loss averse and set their companies on a path to mediocrity.

Where does loss aversion come from? The author Daniel Kahneman in his book “Thinking, Fast and Slow” writes at length about loss aversion. One of his key observations is that human beings behave in irrationally risk seeking or risk averse manners (versus the probability-weighted expected value). If presented with the choice of winning a $1,000 with a 10% probability or making $120, many would be risk seeking and go for the $1,000 choice (though the expected value is lower). With losses, the opposite is true. If there is even a small chance they may lose what they have earned, people will go to great lengths to protect against the loss. They will buy insurance for exorbitant amounts. Companies will make bad long-term choices in favor of shorter term ones to protect against missing their quarterly earnings and taking a loss on the value of their stock. They will be loss averse.

The interesting thing is that many of the best companies start by being risk-seeking. They dream of amazing things – they take risks on markets, people and products. They take risks that most existing companies would not deem feasible and when those risks pay off, they pay off in significant gains. And yet, as those companies become more successful they become fundamentally risk averse. That risk or loss aversion manifests in so many ways: they under-invest in new products; they are unwilling to hire people with less experience; they spend money on risk-mitigation systems; they build in all kinds of cushions into their forecasts and they take their marketing in a conservative direction. Why do the most risk seeking of individuals, entrepreneurs, become loss averse? For a variety of reasons:

Short-term gain, long-term loss: As companies grow, the consequences of loss aversion are often not felt immediately. They are felt over time as investments become non-productive. But in the short term, it can often feel like the conservative decision is the winner. The experienced hire might not be the right one long term, but often looks better in the short term.

Fear of losing everything: It’s so hard to build a successful startup, that the pain of losing everything is nothing short of emotionally scarring. Aspiring to greatness, seeing that goal come into view and then failing is a devastating fear that pushes many leaders in a more conservative direction.

Baggage of success: Even a reasonable modicum of success comes with baggage. Scaling the product seems to need an unending number of people. Scaling sales and marketing seems to need an unending amount of investment. Scaling the operations can feel like the hard 20% that takes you from 80% “good enough” to 100% “great.”

We try hard at BloomReach to prevent loss aversion from naturally setting in (and don’t always succeed). We allocate a certain percentage of our R&D efforts to more experimental projects. We identify certain roles where we are willing to promote people without the experience for the role. We establish a cultural value in “thinking” – and promote out-of-the-box thinking in a range of areas. We actively have conversations about whether or not we are making the right trade-offs between “innovating” and “scaling.” We discuss failure openly. We try to ensure that the short-term choices we make are leading us to the long-term destination we are trying to reach. It gets harder and harder to make these choices as we grow and scale. And yet it becomes ever more important. Loss aversion seems to compound as one grows. Each individual becomes loss averse. Each team inherits each individual’s loss aversion and layers on a new layer of it. Each function hedges on the other functions, feeling like they cannot take risks without the cooperation of other functions. And then the CEO and founders inherit all of that loss aversion and add a new layer of conservatism for presentation to the Board and shareholders.

Loss-aversion is among the most corrosive behaviors at a startup that is aiming for significant impact and growth. The road to mediocrity is paved with a thousand “rational” decisions. Lets make sure we all make a couple of well-timed irrational ones.